Price vs. Value: How Traders Use
Option-Pricing Models
Like in the common-life example just discussed, the right to buy or sell an
underlying security—that is, an option—can have value, too. The specific
value of an option is determined by supply and demand. There are several
variables in an option contract, however, that can influence a trader’s
willingness to demand (desire to buy) or supply (desire to sell) an option at
a given price. For example, a trader would rather own—that is, there would
be higher demand for—an option that has more time until expiration than a
shorter-dated option, all else held constant. And a trader would rather own a
call with a lower strike than a higher strike, all else kept constant, because it
would give the right to buy at a lower price.
Several elements contribute to the value of an option. It took academics
many years to figure out exactly what those elements are. Fischer Black and
Myron Scholes together pioneered research in this area at the University of
Chicago. Ultimately, their work led to a Nobel Prize for Myron Scholes.
Fischer Black died before he could be honored.
In 1973, Black and Scholes published a paper called “The Pricing of
Options and Corporate Liabilities” in the Journal of Political Economy ,
that introduced the Black-Scholes option-pricing model to the world. The
Black-Scholes model values European call options on non-dividend-paying
stocks. Here, for the first time, was a widely accepted model illustrating
what goes into the pricing of an option. Option prices were no longer wild
guesswork. They could now be rationalized. Soon, additional models and
alterations to the Black-Scholes model were developed for options on
indexes, dividend-paying stocks, bonds, commodities, and other optionable
instruments. All the option-pricing models commonly in use today have
slightly different means but achieve the same end: the option’s theoretical
value. For American-exercise equity options, six inputs are entered into any
option-pricing model to generate a theoretical value: stock price, strike
price, time until expiration, interest rate, dividends, and volatility.